You Can’t Cut Your Way To Growth

It’s funny how sometimes the thing you’re sure will save a business ends up hurting it the most. For example, take the Brazilian private equity firm 3G Capital. Over the past decade 3G became the darling of Wall Street by taking mature brand portfolios with flattish sales and making them more profitable by slashing expenses. Even Warren Buffett’s Berkshire Hathaway invested heavily in 3G Capital because they seemed to be able to squeeze their acquisitions for higher profits quarter and quarter.

3G employs two strategies to cut costs – job elimination and some called Zero Base Budgeting. To give you an example of the job reductions, since 3G purchased Kraft Heinz in 2015 they’ve reduced the company’s overall global workforce by 20% – that’s a huge drop for a manufacturing and distribution-heavy CPG. Then there’s the even more draconian Zero Base Budgeting. The concept requires expense-side budgets to start at zero every year, which requires managers to build a budget from scratch every cycle instead of increasing/decreasing spending off the prior year’s actuals. This forces managers to defend every penny they plan on spending – even down to the cost estimates for the tomatoes used to make Heinz ketchup.

Last week 3G’s cost savings rocket fall back to Earth when Kraft Heinz, announced disastrous Q4 earnings, which capped six straight quarters of declining sales and added a new SEC investigation into the company’s accounting practices. As a result KH’s stock dropped 30% – shaving an unbelievable $16B off their valuation. To give you an idea of how bad things have suddenly gotten, 3G co-founder Jorge Paulo Lemann was recently quoted as saying, “I’m a terrified dinosaur. I’ve been living in this cozy world of old brands and big volumes. You could just focus on being very efficient and you’d be OK. All of a sudden we are being disrupted in all ways.” Admissions like this have to send shivers up 3G investors’ spines.

So what’s the business lesson in all of this? For me it’s that even mature brands need to be nurtured with investment in product and marketing. Cost cutting might be needed at times, but you can’t rely on it year after year as your primary business strategy. Because eventually you’ll run out of fat to cut, and end up sawing into the muscle and bone brands need to stay strong.